beasley - 1996 - an empirical analysis of the relation between the board of director composition and financial statement fraud

An Empirical Analysis of the Relation between the Board of Director Composition and
Financial Statement Fraud
Author(s): Mark S. Beasley
Source:
The Accounting Review,
Vol. 71, No. 4 (Oct., 1996), pp. 443-465
Published by: American Accounting Association
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THE ACCOUNTING
REVIEW
Vol. 7 1, No.
4
October 1996
pp.
443-465
An
Empirical
Analysis
of

the
Relation
Between
the
Board
of
Director
Composition
and
Financial
Statement
Fraud
Mark
S. Beasley
North
Carolina
State
University
ABSTRACT:
This
study empirically
tests
the
prediction
that
the
inclusion
of
larger
proportions of outside members on

the board
of
directors significantly
reduces the
likelihood of financial statement
fraud. Results
from
logit regression analysis
of 75
fraud and 75 no-fraud firms indicate
that no-fraud
firms
have
boards with
significantly
higher percentages
of
outside
members
than
fraud firms; however,
the
presence
of
an
audit committee does
not
significantly
affect
the likelihood of financial statement

fraud.
Additionally,
as outside director ownership
in the
firm
and outside
director
tenure on the
board
increase,
and
as
the number
of
outside
directorships
in
other
firms held by outside directors decreases,
the likelihood of financial statement
fraud
decreases.
Key Words: Audit committees,
Board of director composition, Corporate
gover-
nance,
Financial statement
fraud.
Data
Availability: Data for this paper

come from public sources. A list of
sample
firms
is available
from the author upon request.
This
paper is from
my
dissertation
completed at
Michigan State
University.
I
am
grateful
for
helpful
comments
from
my
dissertation
committee,
Al
Arens
(Chairman),
Mary Bange,
Frank Boster and
Kathy
Petroni.
I

also want to thank
Joe
Anthony, Karen
Pincus, Dewey
Ward,
two
anonymous
reviewers, and
workshop
participants
at
Auburn,
Florida
State,
Georgetown,
Illinois,
Michigan
State,
North
Carolina
State,
Penn
State,
Tennessee,
Wisconsin-Madison,
the 1994 AAA
annual
meeting, and
the
1995

AAA
mid-year
auditing section
meeting.
The
significant
financial
support
provided
by the
Institute of
Internal Auditors
Research
Foundation
is
gratefully
acknowledged.
Submitted
JuIly 1995.
Accepted April
1996.
Editor's
Note:
This
paper
is
the
winner of
the 1995
AAA

Competitive
Manuscript
Award.
443
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444
The
Accounting Review,
October 1996
I.
INTRODUCTION
T
his
study
empirically examines
the
relation between
board of director composition
and
the
occurrence
of financial statement fraud. Fama and
Jensen (1983) theorize
that the
board
of
directors
is the
highest

internal
control mechanism
responsible for
monitoring the
actions of top
management. They argue
that outside directors
have incentives to carry
out their
monitoring tasks
and not to collude with
top managers to expropriate
stockholder
wealth, so the
inclusion of outside
directors increases
the board's ability to
monitor top management
effectively
in
agency settings
arising from the separation
of corporate
ownership and decision
control.
Because there are
wide variations among
firms in the degree of
representation of outside
members

on
boards
of directors (Baysinger and
Butler 1985), this study
examines variations
in board of
director
cosmposition
to
test empirically
the
prediction that
the inclusion of outside
members on
the board
helps
reduce occurrences
of financial statement fraud.
Existing
empirical
research
provides
evidence about the
importance of including
outside
directors
on the board
for
purposes
of

monitoring management
in acute agency settings
other than
those
involving
financial
statement fraud.
In
management buyouts,
shareholder
wealth increases
when boards are
dominated by outside
directors (Lee et al.
1992); firms resisting
greenmail
payments
have
more
outside directors
relative to
boards
of firms not resisting greenmail
payments
(Kosnik 1987,
1990); expenditures
on
salaries are negatively
related to the percentage
of outside

members on the board
of
director
(Brickley
and James 1987);
and turnover of chief
executive
officers
for
poorly
performing
firms
is
highest
with boards of
directors having high
proportions
of outside directors
(Weisbach 1988).
While these
studies
support
the
prediction
that board of
director
composition
is
related
to the

board's effectiveness
at
reducing agency
costs,
none has
examined board
of
director
composition
in the
context
of
financial statement
fraud.
The
relation
between
board of director
composition
and occurrences
of
financial
statement
fraud
is
particularly
important
to the
accounting profession,
because accountants

have a
responsibility
to
identify
situations
where
financial
statement fraud has a
greater
likelihood of
occurring.
Auditing
standards
explicitly
require
auditors
to
provide
reasonable assurance that
material
financial
statement
fraud is detected
(paragraph
.08
of
AICPA
Statement
on
Auditing

Standards
(SAS)
No.
53,
The Auditor's
Responsibility
to Detect and
Report
Errors
and
Irregularities (AICPA
1989a)).
Palmrose
(1987)
notes
that financial
statement fraud accounts
for
about half
the
litigation
cases
against
auditors.
Auditors
are
required by
AICPA SAS
No.
55,

Consideration
of
the Internal Control
Structure in a
Financial Statement
Audit
(paragraph .20)(AICPA
1988b),
to
obtain
a
"sufficient
knowledge
of the
control
environment to understand
management's
and the board
of
director's
[emphasis
added] attitude,
awareness and actions
concerning
the
control
environment."
Even
though
this

requirement
exists,
auditing professional
standards, particularly
the "red
flag"
indicators
of financial
statement
fraud described
in
SAS
No.
53,
are silent as
to
board
of director
characteristics
that
may
affect
the board'
s
ability
to monitor
management
for the
prevention
of

financial statement fraud.
The lack of
explicit guidance
about board characteristics
in the
professional
standards
may
be attributed
to
the
lack of
empirical
evidence
in
prior
management
fraud research.
Studies
in
that
body
of
research,
such
as Loebbecke
et al.
(1989)
and
Bell et

al.
(1991),
note the
significance
of
"weak
internal
control
environments"
that allow
management
to
carry
out
such
fraud.
Given that
little is known about
the
nature
of these "weak internal control
environments,"
particularly
board
governance,
this
study
examines
whether board
composition

differs for firms
experiencing
financial statement fraud
from those
not
experiencing
such
fraud.
Evidence on this
relationship may provide
important insights
for
accounting professionals
who
seek
to
identify
circumstances
where the risks of financial statement
fraud are increased.
This
study
tests the
prediction
that the
proportion
of outsiders on the board
of
director
is lower

for firms
experiencing
financial
statement fraud than
for
no-fraud
firms.
Outside
directors
are
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Beasley-Board
of
Director
Composition
and
Financial Statement
Fraud
445
defined
to be
all
non-employee
directors. The research
methodology
uses
logit
cross-sectional
regression

analysis
to
examine
differences
in board of director
composition
between
75 fraud
and
75
no-fraud
firms
that
are similar in
size,
industry,
national
exchange
where common stock
is
traded,
and
time
period.
More
importantly,
the
regression
analysis
controls

for
differences
in
motivations
for
management to commit
financial statement
fraud
and
for
conditions
that
enable
management
to override
board
monitoring
to
carry
out the
fraud.
This
study's
definition of financial statement fraud is limited
to two
types.
The first
type
includes
occurrences where

management
intentionally
issues
materially
misleading
financial
statement
information to outside
users. The
second
type
includes occurrences
of
misappropria-
tions of
assets
by
top
management.
Top
management
includes
the
chairperson,
vice
chairperson,
chief
executive
officer,
president,

chief
financial
officer and
treasurer.
As
noted
in
paragraph
.03
of
SAS No.
53,
these
two
types
of fraud
represent
intentional
misstatements
or
omissions
of
amounts
or
disclosures
in financial
statements.
The
empirical
results confirm

the
predicted
relation
between
board
of
director
composition
and
the
occurrence
of
financial
statement fraud.
The
results show
that
no-fraud firms
have
significantly
(p
<
.01)
higher
percentages
of
outside
directors
than
fraud firms.

Additional
analysis
indicates that
the
empirical
tests are
not
sensitive to the
definition of
outside
directors
used.
Furthermore,
because
boards of
directors
often
delegate
responsibility
for
oversight of the
financial
statement
reporting
process
to an
audit
committee, additional tests
are
performed

to
consider
whether
the
presence of
an
audit
committee
significantly
affects
the likelihood
of
financial
statement
fraud. Results
indicate that
board
composition
continues
to differ
signifi-
cantly
across
fraud
and
no-fraud firms
even
after
controlling
for

the
presence of an
audit
committee.
Interestingly,
no-fraud
firms
are not
significantly
more
likely
to
have an
audit
committee, and
the
interaction of
board
composition
with
audit
committee
presence
does
not
significantly
affect
the
likelihood
of

financial
statement
fraud.
A
separate
analysis
of a
sub-
sample
of
firms
having audit
committees
indicates that
there
is
no
significant
difference
in
audit
committee
composition
across
fraud and
no-fraud
firms.
These
results
suggest

that
board
composition, rather than
audit
committee
presence
or
composition,
plays
a
greater
role
in
reducing
the
likelihood
of
financial
statement
fraud.
Supplemental
analysis
of
the
sample
firms is
performed
to
determine
whether

certain
characteristics
of
outside
directors
affect
the
likelihood
of
financial
statement
fraud.
As
the
level
of
stock
ownership
in
the
firm
held
by
outside
directors
increases,
as
outside
director
tenure

on
the
board
increases,
and
as
the
number
of
directorship
responsibilities
on
other
corporate
boards
held
by
outside
directors
decreases,
the
likelihood
of
financial
statement
fraud
decreases.
Additionally, as
board
size

decreases,
the
likelihood
of
financial
statement
fraud
decreases.
The
current
study
continues as
follows.
Section
II
develops
the
underlying
theory
to
motivate
the
hypothesized
predictions
about
board
of
director
composition,
audit

committee
presence
and
the
occurrence
of
financial
statement
fraud.
Section
IHI
describes
the
sample
selection
process.
Section IV
details the
research
design,
and
section
V
contains
the
empirical
results
of
the
study.

Section VI
concludes
the
study.
II.
THEORY AND
HYPOTHESES
DEVELOPMENT
An
important
function
of
the
board
of
director
is
to
minimize
costs
that
arise
from
the
separation
of
ownership
and
decision
control of

the
modern-day
corporation
(Fama
and
Jensen
1983).1
The
board
of
director
receives
its
authority
for
internal
control
and
other
decisions
from
I
Fama
(1980),
Fama
and
Jensen
(1983),
Williamson
(1984) and

Shleifer
and
Vishny
(1986)
note
that
there are
both
external
and
internal
corporate
governance
mechanisms
designed
to
minimize
divergences
that
arise
from
the
separation of
ownership
and
decision
control.
This
study
focuses

on
one
internal
corporate
governance
mechanism:
the
board
of
directors.
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446
The
Accounting Review, October
1996
stockholders of corporations.
This delegation occurs because
stockholders generally
diversify
their
risks
by owning securities
in numerous
firms
(Fama
1980). and such diversification
creates
a
free-rider problem where

no individual stockholder
has a large enough incentive
to devote
resources to
ensure that management is acting
in
the stockholders'
interests (Grossman
and Hart
1980).
Fama and Jensen (1983)
theorize that the stockholders'
delegation of responsibility
for
internal control to the board
of director makes
the
board
the apex of decision control
within both
large and small corporate
organizations.
Although the
board delegates most decision
manage-
ment functions and many decision
control functions to
top management,
the
board

retains
ultimate
control over
top
management. Such control
includes the board's right to
ratify and
monitor important decisions,
and to choose, dismiss
and reward important decision
agents. The
board
of director assumes
responsibility
for
establishing
an
appropriate
control
system
within
the
firm
and monitoring top
management's compliance with
this system.
Fama
(1980)
and Fama
and

Jensen (1983) suggest
that the composition of individuals
who
serve on the board of director
is
an important factor
in
creating
a
board
that is an
effective
monitor
of
management
actions. While
noting
the
importance
of having both
inside (i.e.,
management)
and outside (i.e., nonmanagement)
members on the board of director, they argue that
the
board's
effectiveness
in
monitoring management
is a

function of the mix
of
insiders and outsiders who
serve.
Fama (1980) and Fama
and Jensen (1983) argue
that
it
is natural for the most
influential
members
of the
board
to be
the
internal
managers,
because they have valuable
specific
information about
the
organization's
activities that is obtained from internal
mutual
monitoring
of
other
managers.
Such information
assists

the board
in
being
an effective device for
decision
control.
As
a
result,
Fama
(1980)
and
Fama and
Jensen
(1983)
expect
the
board
to
include
several
of the
organization's top
managers.
However, the board
is not
effective
at
decision control
unless it limits

the decision
discretion
of
individual
top managers.
Williamson
(1984)
notes
that,
because
managers
have
huge
informational advantages
due
to their full-time status
and
insider knowledge, the
board of
director
can
easily
become
an
instrument of
management,
thereby sacrificing
the
interests of stockholders.
Domination

by top
management
on
the
board of director can lead to collusion and
transfer
of
stockholder wealth
(Fama
1980).
As
a
result, corporate
boards
generally
include outside
members
who act
as
arbiters
in
disagreements among
internal
managers
and
ratify
decisions
that
involve
serious

agency problems
(Fama
and
Jensen
1983).
The findings of Rosenstein
and
Wyatt
(1990)
suggest
that
stockholders
value
the
inclusion of outside directors
on
boards
as
evidenced
by
a
positive
abnormal
stock
return
when
outside directors are
added to boards.
Trends in
practice

also
suggest
there
is
a
perceived
value
in the role
played
by
outside
directors.
The
percentage
of
outsiders
present
on
boards
of
directors
is
increasing
with
outside
directors
comprising
a board
majority
of 94

percent
of
manufacturing
firms
polled
in
1992
compared
to 86
percent
in
1989 and
71
percent
in
1972
(Wall
Street
Journal
1993b).
Fama
(1980)
and Fama and Jensen
(1983) hypothesize
that the
viability
of the board
as
an
internal

control
mechanism
is enhanced
by
the inclusion
of
outside
directors
because outside
directors
have
incentives
to
develop reputations
as
experts
in decision control
because the
external
market
for
their
services
prices
them
according
to
their
performance
as outside

directors.
They argue
that most outside directors
of
corporations
are either
managers
or
important
decision
agents
in
other
corporations.
The value of
their human
capital depends primarily
on their
performance
as
internal decision
managers
in other organizations.
Outside directors use
their
directorships
to
signal
to external
markets for

decision
agents
that
( 1) they
are
decision
experts,
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Beasley-Board of
Director
Composition
and Financial
Statement
Fraud
447
(2)
they
understand the
importance
of
decision
control,
and
(3)
they
can
work
with such
decision

control
systems.
Empirical
research
highlights
the
existence
of an external
market
for
corporate
directors that
punishes
individuals for
poor
performance
as
directors.
Kaplan
and Reishus
(1
990)
find
that
top
managers
in
poorly
performing
firms

(e.g.,
dividend
reducing
firms)
have
fewer
opportunities
to
serve as outside
directors
for
other firms.
Gilson
(
1990)
finds that directors
who
leave
boards
of distressed
firms hold
approximately
one-third fewer
directorships
three
years
after their
departures
than
the

number
of
directorships
they
held
at the time
of
their
resignation.
The national
stock
exchanges
specify
certain
audit committee
requirements
which,
in
turn,
affect board
of director
composition.2
In
June
1978,
the
New York Stock
Exchange
(NYSE)
established

a
requirement
that
firms
have audit
committees
composed
entirely
of
independent
directors.
(An
independent
director
is one who is
not
a
part
of
current
management.)
The
other
exchanges
are
less strict. The
American Stock
Exchange
(AMEX)
recommends,

but does
not
require, audit
committees
composed
entirely
of
independent
directors. In
1987,
the
National
Association
of
Securities
Dealers
(NASDAQ)
established a
requirement
that
listed firms
have
audit
committees with at
least a
majority
of
independent
directors.
Accounting

regulators
and
standards-setters
often discuss
the
significance
of the
board of
director as
an
internal control
mechanism
for
the
prevention
of financial
statement
fraud.
The
AICPA's
(1987)
Report
of
the
National
Commission on
Fraudulent
Financial
Reporting,
the

AICPA
(1993)
Special
Report:
Issues
Confronting
the
Accounting
Profession,
and the
AICPA's
(1994)
Strengthening The
Professionalism
of
the
IndependentAuditor contain
recommendations
calling
for
changes
in
board
composition
to
enhance
the board's
independence
for
purposes

of
minimizing
occurrences of
financial
statement
fraud.
In
the
wake of the
banking
crisis,
the
Federal
Deposit
Insurance
Corporation
(FDIC)
implemented
new
audit
committee
composition
require-
ments
mandating the
inclusion of
independent
directors
who, for certain
large

insured
depository
institutions,
must
include
individuals
with
banking
or
financial
expertise.
The
financial
press
documents
a
perceived
relation
between
board of
director
composition
and the
occurrence of
financial
statement
fraud. For
example, the New
York
Times

(1993)
reported
that
following
an
occurrence of
material
fraudulent
financial
reporting,
the
Leslie
Fay
Company
announced the
election
of two
additional
outside
members
"to
give
its
board
a
more
independent
character."
And, the
Wall

Street
Journal
(1993)
reported
that
outside
board
members of
Clayton
Home
Inc.
resigned,
highlighting
their
concern
about
the
firm's
failure
to
investigate a
possible
financial
statement
related
fraud.
Fama's
(1980)
and
Fama

and
Jensen's
(1983)
theory
regarding
board
composition,
prior
empirical
research
and
the
various
recommendations
for
board
of
director
reform
suggest
that
having
a
higher
percentage
of
outside
directors
increases
the

board' s
effectiveness
as a
monitor
of
management.
Therefore,
this
study
empirically
tests
the
following
hypothesis:
Hi:
The
proportion of
outside
members
on
the
board
of
director
is
lower
for
firms
experiencing
financial

statement
fraud
than
for
no-fraud
firms.
The
above
hypothesis
is
based on
the
definition
of
an
outside
director
that
includes
all
non-
employee
directors,
consistent
with
the
requirements of
the
national
stock

exchanges. A
number
of
corporate
governance
researchers
note,
however,
that
the
traditional
distinction
between
inside
and
outside
directors
may fail
to
account
for
the
actual
and
potential
conflicts
of
interests
between
outside

directors
and
the
corporations
they
serve
(Mace
1986;
Patton
and
Baker
1987;
Hermalin
2
As
discussed
later,
this
study
also
considers
the
effects of
having
an
audit
committee.
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448

The
Accounting
Review,
October
1996
and Weisbach
1988, 1991; Lee
et al.
1992;
Shivdasani 1993;
Vicknair et al.
1993). These
researchers
commonly classify
outside directors
into one of
two categories:
"independent
directors"
and "grey directors."
An
independent
director is an
outside director
who has no
affiliation with the firm other
than the affiliation
from being on the
board of director.
In contrast,

grey directors
are outside directors
who have
some non-board
affiliation with the
firm. Grey
directors
are a
potential
source of violation
of board independence
because
of their other
affiliations
with management.
While they are
not current employees
of the firm,
and thus are
considered
to be outside directors,
grey directors'
independence
may be impaired
by being
relatives of
management, consultants
and suppliers
of the firm,
outside attorneys

who perform
legal work for
the firm, retired
executives
of the firm and investment
bankers
(Gilson 1990;
Shivdasani
1993). Vicknair et
al. (1993) find that
74 percent of NYSE
firms have at
least one grey
director on
the
audit
committee.
Fama's
(1980)
and Fama and Jensen's
(1983)
theory regarding
board composition
would
predict that
higher percentages
of independent
directors increase
the board's effectiveness
as a

monitor of
management.
Therefore,
this
study
empirically tests
the following hypothesis:
H2:
The
proportion
of
independent
members
on the
board
of director is lower
for firms
experiencing
financial
statement
fraud
than for
no-fraud
firms.
Often
the board of director
delegates
the
responsibility
for the

oversight
of financial
reporting
to
an
audit committee
(AICPA
1987;
SAS
No.
53;
AICPA
1988a;
AICPA 1993).
Pincus et al.
(1989) note
that audit committees
are
viewed
as
monitoring
mechanisms that are
voluntarily
employed in
high agency
cost
situations to
improve
the
quality

of information
flow
between
principal
and
agent. They
note that the audit committee enhances
the board of director'
capacity
to act as
a
management
control
by providing
more detailed knowledge and understanding
of
financial statements
and other
financial
information issued by
the company.
The
existence
of an
audit committee
can be
perceived
as
indicating higher quality
monitoring

and
should
have
a
significant
effect
on
reducing
the likelihood of financial statement fraud.
Therefore,
this
study
empirically
tests the
following hypothesis:
H3:
Boards of
directors offirms
experiencing
financial statementfraud
are less
likely
to have
an
audit
committee
than boards of directors
of
no-fraud
firms.

III.
SAMPLE
SELECTION
AND
DESCRIPTION
The
sample
used
to test this
hypothesis
consists of 150
publicly
traded
firms.
Seventy-five
of the
150
firms
represent
the "fraud
firms" because
each of these firms had
an occurrence of
financial
statement
fraud
publicly
reported
during
the

period
1980-1991. Each
of
the
fraud firms
is matched
with a
no-fraud
firm, creating
a choice-based
sample
of 75
fraud and 75 no-fraud
firms.
Fraud
Firm Selection
The financial statement
fraud
sample
is limited
to
publicly
traded
firms because
the
study
examines
information
only
available

in
proxy
statements
and
financial statements
filed with the
SEC.
Two sources
were used
to
identify
these
firms. The first
source is
Accounting
and
Auditing
Enforcement
Releases
(AAERs)
issued
by
the SEC.
A firm
reported
in
an AAER is included
as
a
sample

fraud
firm
if
the
SEC accused
top
management
of
violating
Rule
10(b)-5
of the 1934
Securities
Exchange
Act
(the
1934
Act).
Rule
l
0(b)-5 requires
the
intent to
deceive, manipulate
or defraud.
The second
source of fraud
firms is the Wall
Street Journal Index
(

WSJ
Index) caption
of
"Crime-White
Collar
Crime."
In
most
cases,
the firms
identified
in
the
WSJ Index are also
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Beasley-Board
of
Director
Composition
and Financial Statement
Fraud
449
reported
in AAERs. Those
fraud
firms
reported by
the
WSJIndex,

but not in an
AAER,
were
added
to
the sample
as fraud
firms.
The
AAERs
and
the
WSJ
Index
appear
to be reasonable sources
for
identifying
financial
statement
fraud
occurrences
for
two reasons.
First,
almost all of the
applicable
AAERs
contain
a disclosure

that
management personnel
involved
in the financial statement
fraud consented
to
the
final
judgment action imposed
by
the SEC.
Feroz
et
al.
(1991)
note that
the SEC
only pursues
cases where
the
probability
of
SEC success is
high
and
where the
allegations
involve
material
violations.

Second,
for
fraud firms identified
by
review of
the WSJ
Index, management
personnel
involved have
either
resigned,
been
terminated,
or
been
indicted
by
a
grand jury.
Management's
consent,
resignation,
termination
or
indictment disclosed
by
these
two
sources
suggest

a
high
level of seriousness of the
fraud
allegation.
To the extent that
financial
statement
fraud
occurrences identified in
AAERs
and
the WSJ Index are
not
representative
of the
population
of
financial statement
fraud
occurrences,
the
implications
of
this
study
are
limited.
A
fraud

firm
identified
from these two sources
is
included
in the
sample
if
the
appropriate
proxy and financial statement data
are
available
in
the fiscal
year
preceding
the first
occurrence
of
the financial statement
fraud.
Such
proxy and
financial statement
data
were
hand collected
from
the Q-Data SEC Files

(the Q
Files)
which
are on microfiche. Information
about
the
specific
financial
reporting periods
affected
by
the financial statement fraud
was
obtained from the AAER
or
applicable
articles in the Wall Street
Journal.
These two
sources
provide
a
sample
of
75 fraud firms
for
examination. As
noted
in
figure 1,

67
of
the
75 fraud firms are
from
the review of
1982-1991
AAERs,
which include
AAERs #1-#348.
The
remaining eight
fraud firms are
from
the
review of the 1980-1991 WSJ
Index.
AAERs
and
the
WSJ
Index
issues
after
1991 were not reviewed to
allow
a
sufficient
period of
time

to verify
that the related
comparison
group
of
no-fraud firms
(as described
later)
have
not
experienced
financial
statement fraud. Figure
1
reconciles
the number of
AAERs issued from
1982 through
1991
to
the number of
sample
fraud firms
included in this study.
Sixty-seven
(89.3%)
of
the 75 fraud firms
experienced
fraudulent financial

reporting and
eight
firms
(10.3%)
experienced misappropriations of
assets. This
proportion is
consistent with
the
findings
of
the National
Commission on
Fraudulent
Financial Reporting
(AICPA 1987)
which
determined that 87
percent of the SEC
enforcement
actions in
1982-1986 dealt with
fraudulent
financial
reporting.
FIGURE
1
Identification
of 75
Fraud Firms

Number of
Accounting and
Auditing Enforcement
Releases (AAERs)
1982-1991
348
Less:
*
AAERs
not
involving financial
statement fraud
(e.g., unintentional
misapplication of
GAAP)
or AAERs
expanding
other AAERs
(e.g., duplicate
AAERs for same
firm)
(198)
*
AAERs
affecting
firms
with no
available proxy or
financial statement
data

(64)
*
AAERs
affecting banks or
insurance firms
experiencing financial
statement fraud
(16)
*
AAERs
affecting
firms
where no
matching no-fraud
firm can be
identified
(3)
Subtotal of
fraud firms identified
by reviewing AAERs
67
Add:
Allegations of financial
statement fraud reported
by the Wall Street
Journal but not
reported
in
an
AAER

8
Total
number of
fraud firms
included in study
75
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450
The
Accounting
Review,
October 1996
Comparing
Fraud
Firms to No-Fraud Firms
To create a comparison group,
no-fraud firms
were identified
that are similar
to the fraud
firms in size,
industry, national
stock exchange
and time period.
Each fraud firm
was matched
with a no-fraud
firm based on
the following requirements:

1.
Stock
Exchange. The common
stocks
of a fraud firm and its
matched no-fraud
firm trade
on the same national stock
exchange (NASDAQ,
AMEX,
NYSE).
2. Firm
Size.
All
firms
within the
particular
national stock exchange category,
per the
annual COMPUSTAT
tape
that are
in
the same industry
(see step 3) as the
fraud firm,
were
selected
if
those

firms are similar in
firm size. Firms
are considered similar
in firm
size if the
current
market value of common
equity
is withi ?30 percent of
the current
market
value
of common equity
for
the
fraud firm
in
the
year preceding the
year of the
financial statement
fraud.3 4
3. Industry.
All firms identified
in
steps
1
and 2 were reviewed to identify a
no-fraud firm
within

the same four-digit
SIC code as the
fraud firm. The
no-fraud firm selected
was the
one that had a current market value
of
common
equity
closest to the current
market value
of
common equity
of the fraud firm (or
total assets
if
market
data were not
available).
If
no
four-digit
SIC code
firm
match
was
identified, the
same procedure
was
performed to

identify a
firm with the same
three-digit
SIC
code.
If
no
three-digit
match was identified,
the
same procedures
were
performed
to
identify
a two-digit SIC code
match.5
4. Time
Period.
A
no-fraud
firm
identified
in
steps
1
through 3 was included
in
the final
sample

if
proxy
and financial
statement
data
are
available
for the
time
period
used
to
collect
data
from the
proxy
and financial statements
of the
related fraud
firm.
Table 1 shows
that the fraud
and no-fraud firms do not differ
significantly
based on total
assets,
net sales and
current market
value of common stock.
Also,

fraud and no-fraud
firms match
closely
based
on
national stock
exchange,
industry
and time
period.
More
importantly,
the fraud
and no-fraud firms should
ideally
be
similar in the likelihood
of
a financial
statement fraud occurrence.
Loebbecke et al.
(1989)
note that
financial statement fraud
occurs
when
managers
in
positions
of

authority
and
responsibility
in the
entity
are of
a
character
that would
allow them to commit
a fraud
knowingly.
Loebbecke
et al.
(1989)
note that financial
statement
fraud is most
likely
to occur
in
firms where
management
has sufficient motivation to
commit
the fraud
and conditions
exist
within
the

firm
that
allow a material
management
fraud
to
be
carried
out.
This
study
controls
for
differences
in
motivational and conditional
factors identified
in
Loebbecke
et
al.
(1989)
that
are
also known
to affect board
composition,
because their omission
may
otherwise create

a correlated
omitted variable
bias.6
The
specific
control variables
included
3Kaplan
and Reishus
(1990)
create
a
comparison
sample using
a cutoff of ? 50 percent.
While
this study's use
of ?
30
percent
may appear
as a large range,
most of the
fraud firms
and related
no-fraud
firms are
within ? 20
percent.
Given

that
the mean market
value
of common
equity
of the fraud
firms is
$127.6
million,
the related
control
firm size
could
range
from $89.3
million
to $165.9
million.
There is no reason
to believe
that such
a
range
has a significant effect
on
board
characteristics.
4
For
25 of the

75 fraud
firms, no-fraud
firms were matched
on total
assets because
market value
information is not
available
on
the
COMPUSTAT tape
or in the Daily
Stock Price Record
for the
fraud
firm.
5
Twenty-four
of the 75 fraud
firms
were matched
with no-fraud
firms within the same two-digit
SIC
code
category.
Results
reported
in
this

paper
do
not differ
between firms matched
at the
two-digit
level versus firms matched
at the
three
and
four-digit
levels.
6
The
Loebbecke
et al. (1989)
model
also includes
factors related
to
management's
attitude
or
willingness
to
commit
financial
statement
fraud.
Due to the

sample selection
techniques
used
to identify
fraud firms
for this study,
management
(Continued)
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Beasley-Board
of Director
Composition
and Financial Statement Fraud
451
TABLE 1
Matching
of Fraud Firms and No-Fraud
Firms
($
in
thousands)
Fraud-Firms
No-Fraud
Firms
Mean
Mean
[Median]
[Median]
(Standard

Deviation)
(Standard
Deviation)
Total Assets
$103,192
$79,626
[11,130]
[12,487]
(316,734)
(221,187)
n=75
n=75
Net Sales
$102,285
$93,078
[13,0431 [12,9361
(262,875)
(257,451)
n=75 n=75
Current
Market
$127,630
$124,590
Value of
Equitya
[26,563]
[23,660]
(263,370)
(257,690)
n=50 n=50

Stock Traded
on:
NASDAQ
62 62
AMEX
4 4
NYSE 9
9
Match Based
On:
4
Digit
SIC
Codes 19
3
Digit
SIC
Codes
32
2
Digit SIC Codes
24
75
First
Year
of
Fraud:
1979
3
1982 9

1985
11
1988
3
1980
6
1983 13
1986
5
1989
6
1981
3
1984
4
1987
11
1990
1
75
a
Market
price information was
available
for
50
of
the 75
fraud firms.
Thus, no-fraud

firms were matched
based on current
market value
of
equity
for
those 50 firms. For
the remaining 25
fraud firms, no-fraud
firms were
matched based on total
assets.
Note:
Paired t-tests for
means and
Wilcoxon
matched-pair sign-rank test
for medians were
performed to
determine whether fraud
and no-fraud firms
differ
significantly
based
on
Total
Assets,
Net
Sales,
or Current

Market Value of Equity.
No statistically
significant differences
exist.
in
this
study are
identified
in
section
IV, which
describes the logit
regression
analysis used to test
the
hypothesis.
The
identification of
no-fraud firms
will result in
some
misclassification if a
firm classified
as a
no-fraud firm had an
occurrence
of financial
statement fraud
that has yet to be
detected. To

(Footnote
6
continued)
for all
of
the
fraud
firms
has
an
attitude
(or
willingness)
sufficient
to
commit
financial
statement
fraud
given
that
fraud
has
occurred at
those
firms.
However,
this
study
is

unable to
control for
differences
in
management
attitudes for
the
sub-
set of
no-fraud
firms. To
the
extent
that
such
differences, if
any,
relate to
board
composition,
a
limitation
of
this
study
exists.
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452 The
Accounting Review,

October
1996
minimize
this likelihood, the WSJ
Index from 1980 through
early 1994 and all AAERs
were
reviewed
to verify that there was no
report of a financial
statement fraud for each no-fraud
firm.
IV.
RESEARCH DESIGN
The
research design of this
study
involves
logit
cross-sectional regression analysis.
Logit
regression
is
used because the
dependent variable, FRAUD, is
dichotomous (see Stone and
Rasp
1991).
The
estimation

is based on a
choice-based sample in which
50 percent of the firms
have
experienced
financial
statement
fraud and
50
percent have not
experienced financial
statement
fraud. While
there are
no
available
estimates of the number of
publicly traded firms
experiencing
financial
statement fraud, it is very
likely that the true rate
of firms experiencing
financial
statement
fraud
(as
defined in this
study)
within

the total
population
of
publicly traded
firms is
less than
50
percent. Therefore,
the one-to-one
matching process
used in this study differs
from
a
pure
random
sampling approach.
Maddala
(1991)
states that
logit
regression analysis
is
the
appropriate procedure
where
disproportionate
sampling
from two
populations (i.e., the fraud and
no-fraud

firm
populations)
occurs. He notes that "The coefficients
of
the
explanatory variables
are
not
affected by the
unequal
sampling
rates
from the
two
groups.
It is
only
the
constant term that is
affected." Correcting
for
the bias
in
the constant
term
is
only
important
if
the

logit analysis
is
being
used to obtain
parameter
estimates
for
purposes
of
developing
a
predictive
model
(Palepu
1986).
It
is
not
the
purpose
of
this study
to
develop
a
predictive
model
of
fraud,
so bias in

the
constant
term has no
effect
on
the
analysis
and
logit regression
is
appropriate
for
testing
the
hypotheses.
The
following logit
cross-sectional
regression model is used to test the
hypothesized
relation
between
board
of
director
composition
and occurrences of
financial statement fraud described
in
Hi:

FRA
UD,
=
ax+fl%OUTSIDE,+fl2GROWTH1+T3jROUBLE1+f34AGEPUB,
+J3MGTOWNBD
+(1CEOTENURE)+7BOSS+PBLOCKHLDj+E;
(1)
where
i
=
firm
1
through 150;
FRAUD
= a
dummy
variable with
a
value of one when a firm is
alleged
to have
experienced
financial statement fraud and a value
of
zero
otherwise;
%OUTSIDE
=
the
percentage

of
the board members who are
non-employee
directors;
GROWTH
=
the
average
percentage change
in
total assets
for
two
years ending
before
the
year
of
the financial statement
fraud;
TROUBLE
=
a
dummy
variable with
a value of one when
the
firm
has
reported

at least
three
annual net losses in the
six-year period
preceding
the first
year
of
the financial statement
fraud and
a
value of zero otherwise;7
AGEPUB
=
the number
of
years
the
firm's stock has
traded
on a national stock
exchange;
MGTOWNBD
= the cumulative
percentage
of
ownership
in
the
firm

held
by
insiders
(e.g.,
managers)
who serve on
the
board;
This measure is consistent
with the financial
trouble measure used
in DeAngelo and DeAngelo
(1990) and DeAngelo
et
al.
(1994).
A
supplemental
test
using
a different measure for TROUBLE
that reflects the number
of consecutive years
since the last reported
annual
net
loss,
if
any, during the previous
six-year period produces

results that are unchanged
from those reported
in
section V. Thus, the
supplemental test does
not support the belief that
the recency of an
annual
net loss,
rather
than
the number of annual
net losses, provides
an incentive for management
to act fraudulently.
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Beasley-Board
of
Director
Composition
and Financial
Statement
Fraud
453
CEOTENURE
= the number
of
years
that

the CEO
has served
as
a
director;
BOSS
=
a
dummy
variable
with
a value
of one
if the
chairperson
of the
board
holds
the
managerial
positions
of CEO
or
president
and
a
value
of
zero
otherwise;

BLOCKHLD
= the
cumulative
percentage
of
outstanding
common stock shares
held
by
blockholders
holding at least
5
percent of such
shares
and who
are
not
affiliated
with
management.
Blocks
held
by
family
trusts,
company
employee
stock
ownership
plans and retirement

plans
are
excluded
because
the
voting
rights
associated
with those
shares
are
generally
controlled
by
top
management;
and
e
=
the
residual.
The
variable of interest
in
this
study
is
%OUTSIDE,
which
represents

the
percentage
of
the
total
number of
board members
who
are considered
outside directors. The definition of
outside
director used
in
this
study
is
consistent
with
that
used
by
the
national
stock
exchanges.
That
definition
treats
all
directors who

are
not
currently
employed
by
the
firm as an
outside
director
and
treats all
current
employees
as inside
(i.e.,
management)
directors. A
negative
and
significant
coefficient
on this variable
would
support
the
hypothesized
prediction
about
board of
director

composition
and
the
occurrence
of financial
statement fraud.
Seven
control
variables that
relate to
motivational and
conditional
factors
identified
in
Loebbecke et al.
(1989)
are included in
the
logit
model because
they
are
also known
to affect
board
of
director
composition.
GROWTH controls for

differences
in
the extent of
firm
growth
between
fraud
and
no-fraud
firms because
Loebbecke
et
al.
(1989)
and
Bell et al.
(1991)
note that
one
of
the
most
significant "red
flag"
fraud
indicators is the
presence
of
rapid
company

growth.
They
state
that if the
company
has
been
experiencing
rapid
growth,
management
may
be
motivated
to
misstate
the
financial
statements
during
a
downturn
to
give
the
appearance
of
stable
growth.
The

extent of
rapid
company growth
is
also
associated with
board of
director
composition
because
needed
modifications
to
rules, procedures
and
internal
control
mechanisms,
including
board
of
director
composition,
often
lag
behind
high
growth
periods.
Warner

et al.
(1988) find the
lag
between firm
performance and
management
change
can be
up to two
years.
TROUBLE
controls
for
differences in the
degree
of
financial
health
between
fraud
and no-
fraud
firms.
Loebbecke
et al.
(1989)
and
Bell
et
al.

(1991)
note
that
poor
financial
performance
often
causes
management
to
place undue
emphasis on
earnings and
profitability,
thereby
increasing
the
likelihood of
financial
statement
fraud.
Baysinger
and
Butler's
(1985)
results
indicate that
the
degree
of

financial
health
also
affects
board
composition
because
firms
with
above
average
financial
performance
have
higher
percentages of
outside
directors
than
firms
with
below
average
performance.
Gilson
(1990)
finds
that
a
firm's

financial
distress
is
also
associated
with
board
composition
changes
with
boards
shifting to
higher
numbers
of
directors
who are
creditors and
blockholders
subsequent
to the
onset of
financial
distress.
AGEPUB
controls
for
differences
in
the

length
of
time
that
the
firm's
common
stock has
traded in
public
markets.
The
National
Commission
on
Fraudulent
Financial
Reporting
(AICPA
1987,
29)
notes
that new
public
companies
have a
proportionately
greater
risk
of

financial
statement
fraud
because
management
is
especially
pressured to
meet
earnings
expectations.
Additionally,
the
longer a
company
has
traded
in
public
markets,
the
more
likely
it
has
made
changes
to
comply
with

requirements
of the
public
markets,
including
requirements
affecting
board
composition.
MGTOWNBD
controls
for
differences
in the
extent
of
common
stock
ownership in
the
firm
held
by
top
management
serving
on
the
board
as a

director.
Ownership
by
management
directors
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454
The Accounting
Review, October
1996
is considered
because that group of managers
has the greatest likelihood of affecting
who
is
chosen to serve
on the board and
the greatest likelihood
of being
able to influence
board
monitoring to
carry out fraud.8 The
extent of ownership
held by management
can have differing
effects on the
likelihood of financial
statement fraud.

On one hand, Jensen
and Meckling
(1976)
theorize that stock
ownership held
by management
should reduce underlying
agency problems
because the more
stock management
owns, the stronger
their motivation
to work to raise the
value
of the firm's stock.
On
the
other
hand, the extent
of firm ownership
held by management
can
motivate management
to inflate stock values artificially by fraudulent
reporting. Consistent
with
this
view,
Loebbecke
et

al.
(1989)
note that
significant
ownership
in the firm is a key
fraud
motivational
factor. The extent
of
firm
ownership
held by management
directors also
affects
board of
director composition.
Weisbach (1988)
finds that the fraction
of outside directors
is
negatively correlated
with
stockholdings
of
top
management.
Loebbecke
et
al. (1989)

find that
in
75
percent
of the fraud cases
they examined, operating
and financial
decisions are dominated
by
a
single
person. They argue
that this factor creates
a
condition allowing
management to
commit financial statement
fraud. Two
variables, CEOTENURE
and BOSS,
control for the
chief executive officer's ability to affect board
composition and
board
monitoring of
financial statement
fraud. The
CEO's
power to control
the board of director

is often
attributed to
the belief that
the
CEO has by far
the
strongest
voice in determining who
is
on the
board of director,
even
though
boards
have
nominating
committees
(Mace
1986; Patton and
Baker
1987; Vancil
1987).
Hermalin and Weisbach (1988)
note that an established
CEO has relatively
more power
than a new
CEO,
so
CEOTENURE is

included
to control for differences
in
length
of service on the board
for
CEOs. Note that all CEOs of the
sample
firms
serve on their
respective
boards.
In
addition,
BOSS
is included to control for situations where
the
CEO
and
chairperson
positions
are combined
using
a
measure
consistent with that used in
Chaganti
et al.
(1985)
and

Shivdasani
(1993).
Because
the function of
the
chairperson
of the board is to run board of director
meetings
and oversee
the
process
of
hiring, firing,
evaluating
and
compensating
the
CEO,
Jensen
(1993) argues
that the CEO cannot
perform
the
chairperson's
monitoring
function
apart
from
his
or

her
personal
interests.
He
argues
that
it is
important
to
separate
the
chairperson
and
CEO/
president positions
if the
board
is to
be
an effective
monitoring
device.
When
the
positions
of CEO
and
chairperson
are
combined,

the CEO is also able to influence the
composition
of
the
board.
BOSS
controls
for
this
key
leadership
difference between
fraud and no-fraud
firms.
Finally,
BLOCKHLD
controls for
differences
in
the
extent
of
stockholdings
held
by
blockholders
holding
at least
5
percent

of such shares
who are not affiliated with
management.
Shleifer and
Vishny (1986)
and Jensen
(1993)
note that
large
block shareholders
have incentives
to monitor
management
and serve
as
an
additional control
mechanism, thereby
reducing
the
likelihood
of
financial
statement
fraud.
Large
blockholders
also
affect
board of

director
compo-
sition
by
influencing
the
selection
of
members.
Gilson
(1990)
finds that increases
in
outside
director
representation
on the
board of director
is associated with increases
in
blockholder
ownership
in
periods subsequent
to
a
firm's
poor
performance.
V. EMPIRICAL RESULTS

Differences
in Outside
Directors
Board
of
director
composition
differs
between fraud and no-fraud
firms consistent with
Hi
on
a
univariate basis.
Boards of fraud firms have
significantly
fewer outside members and
more
management
directors than
no-fraud
firms. Fraud
firms have
boards
with
50.2%
(50%)
of their
x
Results are

unchanged
if
ownership
held
by
all
managers
who are officers
is
considered, regardless
of
whether the
manager
does
or
does
not serve
on the board of directors.
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Beasley-Board
of Director
Composition
and
Financial Statement
Fraud
455
membership
on
average

(median)
composed
of
outside
directors,
while
no-fraud
firms
have
boards with
64.7%
(64.3%)
of their
members
on
average
(median)
composed
of outside
directors.
Both
mean and
median differences are
significant
(p<.01,
two-sided)
using
paired
t-tests
and

Wilcoxon
matched-pair
signed
rank tests.9
However,
while
univariate
differences in
board
composition
exist,
the
logit
regression
model
offers
advantages
over
this
comparison
because
it
controls
for firm
specific
differences
known
to have
an effect
on board

composition
and
the
likelihood of
financial statement
fraud.
Table 2
contains
the
logit
cross-sectional
regression
results
for
the
75
fraud and 75
no-fraud
firms.
The
Chi-square
test
of the
model's fit
of 27.794
(8
degrees
of
freedom)
is

significant
at
the
.0005
level,
rejecting
the
null
hypothesis
that the
coefficients
are
simultaneously
equal
to
zero.'0
Like
the
univariate
results,
the
multivariate
logit
regression
results are
consistent with
H
1.
The
coefficient for

%OUTSIDE
is
negative and
statistically
significant
(p<
.0
1).
The
coefficients
for the
control
variables,
GROWTH,
TROUBLE,
AGEPUB, MGTOWNBD,
CEOTENURE,
BOSS and
BLOCKHLD
are not
significantly
different
from
zero,
suggesting
that
these
motiva-
tional
and

conditional
factors
do not
affect the
likelihood of
financial
statement
fraud."
l
Thus,
even
after
controlling
for
firm-specific
factors
believed
to affect
board
composition and
the
likelihood of
financial statement
fraud,
the
logit results
suggest
that
boards
of

no-fraud firms
are
significantly
more
likely
to have a
higher
concentration
of
outside
directors
than
fraud
firms.
This
finding
is
consistent
with
Fama
(1980)
and Fama
and Jensen
(1983)
who
argue
that
outside
directors
are

important
monitors of
management.'2
Differences
in
Grey
and
Independent
Directors
To test
the
prediction
in
H2
that
fraud
firms
have
smallerproportions
of
independent
directors
than
no-fraud
firms, a
logit
regression
model
is
estimated

to
analyze
differences
in
grey
and
independent
directors
between
fraud
and
no-fraud
firms.
This
logit
model
is
based
on
the
logit
model
in
table
2
except
that
%OUTSIDE
(the
percentage

of
board
members
who
are
outside
directors)
is
replaced
by two
variables:
%GRYBOARD
and
%INDBOARD.
%GRYBOARD
represents
the
percentage
of
board
members
who
are
grey
directors
and
%INDBOARD
represents
the
percentage

of
board
members
who
are
independent
directors.
13
The
results
reported
in
table
3
highlights the
significantly
negative
relationship
between
the
likelihood
of
fraud
and
both
the
percentage
of
grey
directors

(p<.05)
on
the
board
and
the
percentage
of
independent
directors
(p<.01). The
results in
table
3
are
consistent
with
the
prediction
in
H2
and
consistent
with
the
results
in
table
2,
thereby

suggesting
that
tests
of
HI
are
not
sensitive
to
the
definition
of
outside
directors
used.
Consideration of
Audit
Committees
Despite
decades
of
encouragement,
audit
committees
were
rare
until
the
late 1
970s

and
are
still
not
universal
(Pincus
et
al.
1989).
Even
though
there
has
been
growth
in
the
number
of
audit
9
Hereinafter,
all
reported
levels of
significance are
based on
two-sided
tests.
'0Stone

and
Rasp
(1991)
note that
the
logit
Chi-square
statistic is
anti-conservatively
biased
when
compared
to
ordinary
least
squares
regression
(OLS),
particularly
for
small
sample
sizes of
50-100.
OLS
regression
performed
to
examine
whether

this
bias
affects
the
conclusions
about
the
fit
of
the
logit model
produces
results
consistent
with
the
logit
model.
The
F-statistic
of
the
OLS
model
is
significant
at
the
.0003
level

with
an
adjusted R2
of.14,
and
there
are no
differences
in
the
significance
levels
of
the
individual
coefficients
between
the
logit
and
OLS
models.
"Prior
research
on
board
composition
in
acute
agency

settings
other
than
financial
statement
fraud
contains
mixed
results
for
these
control
variables.
12Separate
logit
analyses
(not
reported)
indicate
that,
while
board
composition
remains
significantly
different
across
fraud
and
no-fraud

firms, the
interaction
of
board
composition
with
management
ownership
and
the
interaction
of
board
composition
with
blockholder
ownership do
not
significantly
affect
the
likelihood of
financial
statement
fraud.
13The
sum
of
%GRYBOARD
and

%INDBOARD
equals
%OUTSIDE.
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456
The
Accounting Review,
October
1996
TABLE 2
Outside Director Logit Regression Results
75 Fraud Firms Matched
with 75 No-Fraud Firms
FRA
UDi=a+,%OUTSIDEj+,2GROWTHi+,3TROUBLEj+,4AGEPUBi
+,l5MGTOWNBDi+P6CEOTENURE,+P7BOSSi+P8BLOCKHLDi+
Independent Predicted
Estimated Standard
Coefficients
Variable
Relation
Coefficients Errors T-Statistics
00
INTERCEPT
none
2.661
1.126 2.36**
Board Composition:
% of Outside Directors

f31
%OUTSIDE
-
-4.432
1.318
-3.36***
Control Variables
/32
GROWTH none
.111 .146
.76
/33 TROUBLE
none
.428 .453 .94
/34 AGEPUB none
046 .036 -1.28
ASs
MGTOWNBD
none
979 1.217 80
/36
CEOTENURE none
014 .027 52
/37 BOSS
none .579 .476 1.22
168
BLOCKHLD
none 901 1.594 57
Pseudo
R2 .15

Chi-Square
Test
of Model's Fit 27.794
(p=.0005)
(8
degrees
of
freedom)
**,
***
Statistically significant
at less than the
.05,
.01
level,
based
on
two-sided tests.
FRAUD
= a
dummy
variable with a value
of
one when a firm is
alleged
to
have
experienced
financial
statement

fraud and
a value of
zero
otherwise.
%OUTSIDE
=
the
percentage
of the board members who are
non-employee
directors.
GROWTH
=
the
average percentage
change
in
total
assets
for two
years ending
before the
year
of
the
financial
statement fraud.
TROUBLE
=
a

dummy
variable with a value of one
when
a
firm
has
reported
at least three annual
net
losses in the
six-year period
preceding
the
first
year
of the financial statement fraud and
a value
of
zero
otherwise.
AGEPUB
=
the number
of
years
the
firm's
stock has traded
on a national stock
exchange.

MGTOWNBD
= the
cumulative
percentage
of
ownership
in
the
firm held
by
insiders
(e.g.,
managers)
who
serve
on
the
board.
CEOTENURE
= the number
of
years
that
the
CEO has served as a
director.
BOSS
=
a
dummy

variable with
a
value
of
one
if
the
chairperson
of the board holds the
managerial
positions
of
CEO
or
president
and a value of
zero
otherwise.
BLOCKHLD
= the
total
percentage
of
outstanding
shares
of
blockholders
who
hold
at least

5
percent
of
outstanding
shares and are not affiliated
with
management.
?
= the residual.
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Beasley-Board
of
Director
Composition
and
Financial Statement Fraud
457
TABLE
3
Grey and
Independent
Director
Logit
Regression
Results
75 Fraud
Firms
Matched
with

75 No-Fraud
Firmsa
Independent
Predicted
Estimated
Standard
Coefficients
Variable
Relation
Coefficients
Errors
T-Statistics
B0
INTERCEPT
none
2.822
1.152
2.45**
Board
Composition: % of
Outside Directors
8,I
%GRYBOARD
-
-3.299
1.444
-2.28***
/32
%INDBOARD
-

-5.466
1.462 -3.74
Control
Variables
/3
GROWTH
none
.112
.146
.77
/34
TROUBLE
none
.249
.469
.53
/35
AGEPUB
none
051
.037
-1.38
/36
MGTOWNBD
none
-1.380
1.248
-1.11
/37
CEOTENURE

none
019
.028
68
/38
BOSS
none
.822
.504
1.63
,(89
BLOCKHLD
none
931
1.677
56
Pseudo
R2
.17
Chi-Square
Test
of
Model's Fit
31.285
(p=.0003)
(9
degrees
of
freedom)
**,

***
Statistically
significant
at
less than
the
.05,
.01
level,
based
on
two-sided
tests.
a
The results
in
this table
are
based on
the
logit
regression
model
in
table 2
except
that
the
variable
%OUTSIDE

was
replaced
with the
following two
variables:
%GRYBOARD
=
the
percentage
of
board
members
who
are
grey
directors.
Grey
directors
represent
all
outside
directors
who are
related
to
management,
consultants/suppliers
to
the
firm,

outside
attorneys
who
perform
legal
work
for
the
firm,
retired
executives
of
the
firm,
or
investment
bankers
because
they
are
not
viewed
as
being
independent
of
management.
%INDBOARD
=
the

percentage
of
the
board
members
who
are
considered
"independent"
directors-an
outside
director
who
has no
tie
to
the
firm
outside
his/her
role
as
director.
Independent
directors
represent
all
outside
directors
excluding

grey
directors.
committees,
Pincus
et
al.
(1989)
report
that
a
followup
study
on
the
implementation
of
the
National
Commission
on
Fraudulent
Financial
Reporting
recommendations
finds
that
companies
continue
not
to

use
audit
committees.
Review
of
the
sample
firms
included
in
this
study
indicates
that
only 63
percent
of
the
no-fraud
firms
and
41
percent
of
the
fraud
firms
have
an
audit

committee.14
For
the
subset
of
firms
having
an
audit
committee,
the
mean
(median)
size
of
no-
fraud
firm
audit
committees
is
2.7
(3.0)
directors
while
the
mean
(median)
size
of

fraud
firm
audit
committees
is
1.8
(2.0)
directors.
14All
but
two
of
the
firms
without
audit
committees
are
listed
on
NASDAQ.
The
year
of
the
financial
statement
fraud
for
most,

but
not
all,
of
the
NASDAQ
firms
not
having an
audit
committee
precedes
the
year
(1987)
NASDAQ
implemented
an
audit
committee
requirement.
Even
so,
the
subsequent
analysis
provides
useful
evidence
about

the
effectiveness
of
audit
committees in
reducing
the
likelihood
of
financial
statement
fraud.
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458
The
Accounting Review,
October
1996
To examine
whether the
presence
of
an audit
committee is associated with a
reduced
likelihood of fraudulent
behavior,
as
predicted by H3, the variable AUDCOMM is

added to the
logit
model
in
table
2. AUDCOMM
is a
dummy variable
with
a value of one if the
sample firm
has an audit committee
in the
year prior
to the fraud
and a value of zero otherwise.
Additionally,
because
many
of
the
board
composition
reform
proposals (e.g.,
AICPA
National
Commission on
Fraudulent
Financial Reporting

1987;
AICPA
Public
Oversight Board 1993, 1994)
and the
requirements
of the national stock
exchanges
call for
greater inclusion of outside
directors on
audit
committees,
the
presence
of an
audit
committee
indirectly
affects
board
composition if
outside directors
are added to the board to serve on the
audit committee.
Given
that more
no-fraud
firms than fraud firms have
audit

committees,
the
presence of an audit committee may
bias board
composition
for
no-fraud firms
in
a direction
consistent
with
HI.
Therefore,
to examine whether
the interaction of audit committee presence
with
board composition affects the
likelihood of
financial statement
fraud,
the interactive
variable
of
AUDCOMM*%OUTSIDE
is also
added to
the
logit model
in table 2.
Results from this additional logit

regression analysis are presented
in
table 4.
Consistent with
HI,
the
coefficient
on
%OUTSIDE continues
to
be
negative
and
significant (p<.01).
However,
the
results in table
4
are not consistent
with
H3, given
that the
presence
of
an audit
committee has
no significant effect on
the
likelihood of
financial statement fraud, as

evidenced by the
insignificant
coefficient
on
AUDCOMM
(p= .92). Furthermore,
the
interaction of audit commit-
tee
presence
with
board
composition
does
not affect the
likelihood of financial
statement
fraud,
as indicated
by
the
insignificant
coefficient on
the interactive variable
AUDCOMM*%OUTSIDE
(p=.9 1). Thus,
the
results
in table
4

suggest
that
board
composition,
rather
than
the
presence of
an audit
committee,
is
significantly
more
likely
to reduce the likelihood
of financial statement
fraud,
and tests
of
HI
are
not affected
significantly by
the
presence
of an audit
committee.
This
finding
is consistent

with
the
report by
Sommer
(1991) noting
that there is considerable
anecdotal
evidence
that
many,
if not
most,
audit
committees
fall
short of
doing
what
are
generally
perceived
as
their
duties.
To
explore why
audit committees do not
significantly
reduce the
likelihood of financial

statement
fraud,
additional
analysis
is
performed.
As noted
previously,
board
governance
reform
proponents argue
that audit committees
are
more
effective in
carrying
out their
duties
if
they
are
largely (if
not
entirely) composed
of
outside directors.
To
examine whether audit
committee

composition
differs
significantly
between
fraud and
no-fraud
firms,
a
sub-sample
of
fraud and
no-fraud firms that have
audit committees
is
examined.
Only
those
pairs
of
fraud and matched no-
fraud firms
where both the fraud and no-fraud
firms
have an audit committee in
place
are
included
in the
sub-sample.
As a

result,
the
sub-sample
is
relatively
small-26 fraud and 26
no-fraud firms.
On a univariate basis, the no-fraud
firms
have
significantly (p=.03) higher average
percentages
of
outside directors on
the audit
committee
(94 percent) compared
to fraud firms
(84
percent).
However,
results
(not separately
reported)
based
on
a multivariate
logit regression
analysis
indicate that

audit
committee
composition
does not have a
significant
effect on the likelihood of
fraud
(p=.24)
after
controlling
for factors known
to
affect
the
likelihood of financial
statement
fraud and board
composition.'5
The
logit
model examined for the
sub-sample
firms
(n
=
52)
is
similar to the model
shown in table 2
except

that
audit committee
composition
(%OUTAC)
rather
than board
composition
(%OUTSIDE)
is
examined.
While audit committees
for
fraud and
no-
fraud firms are
heavily composed
of outside
directors,
consistent with
many
board reform
15Results are
likely
affected
by
the
relatively
small
sample
size of 26 fraud and 26 no-fraud firms.

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Beasley-Board
of Director
Composition
and Financial Statement
Fraud
459
TABLE
4
Outside
Director and Audit Committees
Logit
Regression
Results
75
Fraud Firms
Matched
with 75 No-Fraud
Firmsa
Independent
Predicted
Estimated
Standard
Coefficients
Variable
Relation
Coefficients
Errors
T-Statistics

P0
INTERCEPT
none
2.619
1.196
2.19**
Board Composition:
% of Outside Directors
,8
I
%OUTSIDE
-4.335
1.602
-2.71***
Effects of Audit Committees
132
AUDCOMM
.149 1.457
.10
/33
AUDCOMM*%OUTSIDE
255
2.342
11
Control Variables
134
GROWTH
none
.112
.146

.77
/35
TROUBLE
none .423 .474
.89
/36
AGEPUB
none
046
.036
-1.28
137
MGTOWNBD none
990
1.241
80
138
CEOTENURE
none
015
.028
54
1p9
BOSS
none
.580 .477
1.22
010
BLOCKHLD
none

910
1.606
57
Pseudo R2
.15
Chi-Square
Test
of Model's
Fit 27.915
(p=.0019)
(10
degrees
of
freedom)
*
*,***
Statistically significant
at
less
than the
.05,
.01
level,
based on two-sided
tests.
a
The results in this
table are based on
the logit
regression

model
in
table 2
except
that
the
following
two variables were added:
AUDCOMM
=
is
dummy
variable
with a value of one if
the
firm
had an audit
committee in
the
year prior
to the
year
of
the financial
statement
fraud and a
value of zero
otherwise.
AUDCOMM*%OUTSIDE
=

is
the
interactive term of
the variable
AUDCOMM
times
%OUTSIDE.
recommendations,
the
presence of the
audit
committee
does not
significantly
reduce the
likelihood of
financial
statement fraud.
The
finding that audit
committees
do not
significantly
reduce the
likelihood of
financial
statement
fraud
can also be
attributed to

the lack of
differences
between fraud
and
no-fraud firms
in
the
number of
meetings
held by the
audit
committee. On a
univariate basis,
both fraud
and no-
fraud firms
met
an average of
1.8 times
(median of 2
times)
during the year
preceding
the fraud.
Furthermore, 35
percent of
the fraud and I
1
percent of
the no-fraud

firms never
held a meeting
during
the
year.'6 This
frequency is
in sharp
contrast to
the
recommendation noted
in the 1993
report
prepared by Price
Waterhouse (1993)
for the
Institute of Internal
Auditor's
Research
Foundation
titled,
Improving
Audit
Committee
Performance:
What Works
Best, that
audit
committees meet
at least
four

times
per year
and make
provisions for
special
meetings when
warranted.
16Results
in
table
4
are
unchanged if the variable
representing
the existence of
an audit
committee is
replaced with a
variable
representing the
presence of an audit
committee
meeting at least
once during the
year.
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460
The
Accounting

Review,
October
1996
Supplemental
Analysis of Other
Board
Characteristics
The
empirical
results
reported in
tables
2, 3,
and 4 are
all
consistent
with the
hypothesis that
the
presence of
non-employee directors on
the
board
increases
board
monitoring
activities
that
help reduce the
likelihood of

financial
statement
fraud.
As
previously
noted,
fraud
firms have
boards
composed of 50.2%
outside
directors on
average
whereas
no-fraud
firms have
boards
composed
of
64.7%
outside directors.
Given
that
the mean
(median)
board size
of fraud
firms is
6.2
(6.0) compared

to
6.7
(6.0)
for
no-fraud
firms,
the
difference in
monitoring
effectiveness
between
fraud
and
no-fraud firm
boards is
largely
accounted for
by
having one
additional (on
average) outside
director on
no-fraud firm
boards.
Perhaps, in
addition
to a
greater
number
of

outside directors
on
no-fraud
firm
boards,
certain
characteristics of
individuals
who
serve as
outside
directors on no-fraud firm
boards
also
help reduce the
likelihood of
financial
statement
fraud. Other
than
the
greater
presence of
outside directors on
the board
of
no-fraud firms
relative
to
fraud

firms,
little is known
about
characteristics
of
those
outside
directors who
serve. Prior
experiences as
director and incentives for
monitoring
management
likely
affect
their
performance
on a
particular
board.
A
supplemental
logit
analysis
is
performed to
obtain
additional
knowledge
about how

certain
characteristics of
outside
directors
affect
the
likelihood
of
financial
statement
fraud.
This
supplemental
analysis is
based on
a
logit
model
similar
to the
one in
table 2
except that
it
also
includes three
characteristics
of
outside
directors:

OUTOWNBD:
representing
the
cumulative
percentage
of
common
stock
shares
of
the
firm
held
by
outside
directors.
OUTTENURE:
representing
the
average
tenure of outside
directors on the
board.
DIRECTSHIP:
representing
the
average
number
of
directorships

in
other
firms
held
by
outside directors.
Jensen
(
1993) argues
that
encouraging
outside
directors to hold
substantial
equity
interest
in
the firm
would
provide
better incentives for
monitoring top
management.
Mace
(1986)
and
Patton
and
Baker
(

1987)
believe
that a director with
a sizeable
stake
in
the firm is
more
likely
to
question
and
challenge
management's
proposals.
Shivdasani
(1993)
finds
that outside
directors
in
hostile
takeover
target
firms
(i.e.,
firms
subject
to
disciplinary

takeover)
have
significantly
lower
ownership
stakes in the
firm,
which
is
consistent
with
the view that
equity
ownership
in
the firm
provides
outside directors with
greater
incentives to monitor. The
variable
OUTOWNBD
is
included
in
the
supplemental
logit
model to
determine whether

the
extent
of
outside director
ownership
in
the
firm
affects the
likelihood of
financial statement
fraud.
The
outside director's
lack
of
seniority
on the
board
likely
affects his/her
ability
to
scrutinize
top
management.
On
the
one
hand,

more
senior
members on the
board
of
director
are less
susceptible
to
group pressures
to conform.
Consistent with
this
view,
Kosnik
(1990)
finds that
outside directors
are
significantly
more
likely
to
resist
greenmail
payments
as
their
average
board

tenure
increases. On the other
hand,
outside
directors with
longer
tenures on
the
board
are
more
likely
to be
entrenched
with
top
management
and new
directors are
more
likely
to
be
independent
and
vigilant.
The variable OUTTENURE is
included
to
determine whether

board tenure of
outside
directors
significantly
affects the
likelihood
of
financial statement
fraud.
Fama
(1980)
notes
that incentives
for
outside
directors to monitor
management
are
provided
by
the
market
for
outside directors. Outside
directors have
incentives
to be
good
monitors
because

being
directors of well-run
companies
signals
value to the external
market
which rewards them
with
additional
directorships.
Under this line of
reasoning,
the number of
additional outside
directorships
held
by
each outside director serves
as
a
measure of the
director's
reputation
as a
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Beasley-Board
of Director
Composition
and Financial

Statement
Fraud
461
monitor.
Consistent with this
view,
Shivdasani
(1993)
finds that outside
directors of
hostile
takeover firms have
significantly
fewer additional
directorships
in other firms
thereby
suggesting
that
outside directors of
hostile
targets
are
less
reputed
monitors.
In
contrast,
as Morck et
al.

(
1988)
note,
monitoring
of
top
officers
requires
time
and effort. As the
number
of
additional
directorships
on
other firm
boards
increases,
demands on
the
individual
board member's time
decrease
the
amount
of
time
available
for
the

director to fulfill
monitoring
responsibilities
at
a
single
firm.
The
variable
DIRECTSHIP
is
included in
the
supplemental
logit
model to
determine
whether
the
number of
additional
directorships
held
by
outside
directors
significantly
affects the
likelihood
of

financial
statement
fraud.
In
addition
to
examining these three
characteristics of
outside
directors,
the
supplemental
logit
analysis
also
examines
whether
board size
significantly
affects the
likelihood of
financial
statement
fraud. Jensen
(1993)
believes
that a
smaller
board of
director

plays
a
controlling
function
whereas
a
larger
board of
director is
easier
for
the CEO
to
control. In
contrast,
Chaganti
et
al.
(1985) believe
large
boards
are
valuable for
the
breadth
of
their
services.
They
find

that
firms
filing
for
Chapter
11
bankruptcy
protection have
smaller
boards than
non-failed
firms,
suggesting
that a
larger board
is
more
effective
in
preventing
corporate
failure.
Some
may
expect
board
size
and firm
size to
be

highly
correlated
thereby
suggesting
little
likelihood
that
board size
differs
across
fraud
and
no-fraud firms
because
fraud and
no-fraud
firms
were
matched
based on
firm
size.
However, given the
Pearson
correlation
coefficient of
only
.49
between
board

size
and
total
assets,
the
variable
BOARDSZ
is
included in
the
supplemental
analysis
to
determine
whether
board
size
significantly
affects
the
likelihood of
financial
statement
fraud.
Table
5
presents
the
results
from

the
supplemental
logit
regression
model.
Not
only
do
the
results
continue to
support
H
I
with
the
significant
(p<
.01)
negative
coefficient for
%OUTSIDE,
but
the
results
indicate
that
certain
characteristics
of

outside
directors
significantly
affect
the
likelihood of
financial
statement
fraud.
The
negative and
significant
(p=.08)
coefficient for
OUTOWNBD
suggests
that as
the
level
of
ownership
of the
firm's
common
stock
held
by
outside
directors
increases,

the
likelihood
of
financial
statement
fraud
decreases.
This
result is
consistent
with
the
view
that
increases
in
outside
directors'
ownership in
the firm
strengthen
incentives
for
outside
directors to
monitor
manage-
ment for
the
prevention of

financial
statement
fraud.
The negative
and
significant
(p=.05)
coefficient
for
OUTT'lENURE
suggests
that
as
the
number
of
years
of
board
service
for
outside
directors
increases,
the
likelihood
of
financial
statement
fraud

decreases.
This
result
is
consistent
with
the view
that
the
years
of
service
increase
the
outside
directors'
ability
to
monitor
management
effectively
for
the
prevention
of
financial
statement
fraud.
The
positive

and
significant
(p=.008)
coefficient
for
DIRECTSHIP
indicates
that as
outside
directors
of
fraud
firms
hold
more
directorship
responsibilities
in
other
firms,
the
likelihood
of
financial
statement
fraud
increases.
This
result
is

consistent
with
the
view
that
additional
directorships
held
by
outside
directors of
fraud firms
distract
those
outside
directors
from
their
monitoring
responsibilities,
thereby
increasing the
likelihood
of
financial
statement
fraud.
17
Separate
piecewise

logit
analysis
(not
reported)
indicates
that
when
the
number
of
directorships in
other
firms
exceeds
2.0,
financial
statement
fraud is
more
likely;
however,
when
the
number
of
other
directorships
is
less
than

2.0,
there is
no
significant
effect on
the
likelihood
of
financial
statement
fraud.
'7One
might
expect
that
the
number of
additional
directorships
is
highly
correlated
with
the
outside
director's
age.
However,
the
Pearson

correlation
coefficient
of
DIRECTSHIP
and
OUTDIRAGE
(average
age
of
outside
directors) is
.32.
Also,
consideration
of
differences of
OUTDIRAGE on
an
univariate basis
and in
a
multivariate
logit
model
similar
to
the
one
in
table

5
shows
no
significant
difference in
age
while
DIRECTSHIP
remains
significantly
different
across
fraud
and
no-fraud
firms.
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462
The
Accounting
Review, October
1996
TABLE 5
Supplemental
Analysis
of Outside
Director
Characteristics
and

Board
Size
Logit
Regression
Results
75
Fraud
Firms
Matched
with 75
No-Fraud
Firmsa
Independent
Predicted
Estimated
Standard
Coefficients
Variable
Relation
Coefficients
Errors
T-Statistics
180
INTERCEPT
none
2.073 1.240 1.67*
Board
Composition:
%
of Outside Directors

18l
%OUTSIDE
-5.060
1.458 3.47***
Characteristics
of
Outside
Directors
182
OUTOWNBD
none -3.532
2.016 -1.75*
f33
OUTENURE
none
135
.070 -1.93*
f34
DIRECTSHIP
none
.668
.250
2.67***
Board Size
As
BOARDSZ
none
.157
.092
1.71*

Control
Variables
I86
GROWTH
none
.004
.134 .03
f57
TROUBLE
none
.759 .506
1.50
P8
AGEPTUB
none
025
.042
60
fB9
MGTOWNBD
none 488
1.372 36
,B30
CEOTENURE
none
.015
.035
.43
P,11
BOSS

none
.234
.514
.46
P12
BLOCKHLD
none
-1.700
1.780
96
Pseudo
R2
.24
Chi-Square
Test
of Model's
Fit
41.998
(p=.0001)
(12
degrees
of
freedom)
*
7***
Statistically
significant
at less than the
.10,
.01

level,
based
on
two-sided
tests.
a
The results
in this table are based
on the
logit
regression
model
in
table
2
except
that the
following
four variables
were
added:
OUTOWNBD
=
the cummulative
percentage
of
outstanding
common stock shares
held
by

outside
directors.
OUTTENURE
=
the mean
number
of
years
that outside directors
have served
on the board
of
direc-
tors.
DIRECTSHIP
=
the mean
number
of additional
directorships
held
by
outside directors.
BOARDSZ
=
the number
of members
on the
board of directors.
In addition

to
certain
characteristics
of
outside
directors,
the
size
of the board
also
significantly
affects
the
likelihood
of financial statement
fraud.
The
positive
and
significant
(p=.09)
coefficient
on
BOARDSZ indicates
that
as
board
size increases
the likelihood
of

financial
statement
fraud
increases.
This
result
is consistent
with Jensen's
(1993)
view that
smaller
boards
provide
more of
a
controlling
function
than do
larger
boards.
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Beasley-Board
of
Director
Composition
and
Financial
Statement Fraud
463

VI.
CONCLUSIONS
The
empirical
results
of
this
study
confirm
the
prediction
that
the
proportion
of
outside
members on the
board of director is lower for
firms
experiencing
financial
statement
fraud
compared to
no-fraud firms.
Results
from
logit
regression
models that

control for
cross-sectional
differences
in
important
firm-specific
characteristics
suggest
that the
inclusion of
outside
members on
the board of
director increases the
board's effectiveness at
monitoring
management
for the
prevention of
financial statement
fraud. The
results also indicate that
board
composition,
rather
than
audit
committee
presence,
is

more
important
for
reducing
the
likelihood
of
financial
statement
fraud.
Finally,
the
supplemental
analysis
shows
that not
only
does
board
composition
significantly
affect the
likelihood
of
financial
statement
fraud,
but board size
and certain
outside

director
characteristics also
affect the
likelihood of financial
statement
fraud.
While the
results
reported
in
this
study
confirm
many
of
the
board of
director
composition
reform
proposals
suggested
by
groups
such
as the
National
Commission on
Fraudulent
Financial

Reporting
and
the
AICPA's
Public
Oversight
Board,
additional
research
is
warranted.
Little
knowledge
exists
about
processes of
boards,
particularly
information
describing how
differing
levels of
board
composition
affect the
nature of
board
activities.
Insight
about

the
processes
outside
directors
use to
exert
control over
board
activities,
including
the
nature
of
issues
discussed,
information
presented to the
board,
and the
frequency
of
formal
and
informal
(e.g.,
conference
calls)
meetings,
would
contribute to

existing
knowledge.
Furthermore,
given
that
the
results do
not
confirm
previous
recommendations
supporting
the
effectiveness of
audit
commit-
tees for
the
prevention
of
financial
statement
fraud,
additional
study
is
needed
to
provide
increased

understanding
of
issues
related
to the
nature
and
processes
unique to
audit
committees,
similar
to
those
board
specific
issues
previously
noted.
Such
knowledge
would
contribute
to
increased
understanding
of
how
audit
committees

effectively
fulfill
their
financial
reporting
oversight
responsibilities.
Finally,
while
the
supplemental
analysis
included
in
this
study
highlights
certain
outside
director
characteristics
that
help
reduce
the
likelihood
of
financial
statement
fraud,

additional
study
of
other
individual
director
characteristics,
such
as
differences
in
personality,
management
style,
and
other
behavioral
characteristics,
may
be
warranted.
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